Saturday, May 22, 2010

Just over one year ago, when "fiscal stimulus" was all the rage, I asked what I thought was a simple question: How do the proponents of fiscal stimulus know that it works? More precisely: what evidence can we bring to bear on the question of whether a large increase in government spending during a peacetime economic crisis stimulates GDP in a welfare-improving manner? (I allowed for the possibility that such a spending program may have desired redistributional aspects, but redistribution is patently not what people talk about when they speak of the benefits of fiscal stimulus--it is something that is supposed to make us all better off).

I appeared to have hit a nerve with some people on this topic. One chap named Bruce Wilder was particularly amusing (that is, if you find appalling ignorance and santimonious drivel amusing). This "debate" had the side benefit of leading me to think about a theory of religion. In any case, the record of this exchange can be found here:

As far as I was (am still) concerned, it all boiled down to personal beliefs (religion). There is simply not enough data (as far as I am aware of) that could lead any honest (agnostic) scientist to come down strongly on one side of the debate or the other. It led me to question to academic integrity of strong proponents of fiscal stimulus like Paul Krugman and Brad DeLong. (I do not feel quite the same way for strong opponents, as they are usually more honest about their beliefs: they simply do not want the government to interfere in the lives of its citizens, period. However, this may simply reflect a defect or bias on my part).

And then along comes Greg Mankiw, a self-described Keynesian. He recently published this in the Federal Reserve Bank of St. Louis Review: Questions About Fiscal Policy.

Mankiw is a gifted writer. I encourage you to read it. He begins the paper with a great analogy. But what I really loved was this line:

I am actually a believer in Keynesian theory; much of my research is in that field. But even as a believer in many aspects of Keynesian theory, I appreciate that you cannot approach this subject matter without showing some humility about what we, as economists, can truly be confident about.

My only quibble is why he only included economists in that worthy sentiment.

Tuesday, May 18, 2010

An excellent piece today by John Cochrane in the WSJ here. Here it is (in case you do not subscribe).

====================

Last week the Greek bailout ballooned into a gargantuan 750 billion euro (nearly $1 trillion) debt stabilization fund, including a $39 billion line of credit from the International Monetary Fund. This coincided with the European Central Bank (ECB) announcement that it would immediately begin purchasing junk-rated Greek debt.

It won't work. The problem isn't liquidity, psychology or speculators. Germany and France simply cannot borrow or tax enough to cover Europe's debts and looming deficits. So, barring a fiscal and growth miracle, we will either see sovereign defaults (larger and more chaotic for having been postponed) or the ECB will have to print euros to buy worthless debt, leading to widespread inflation. Since inflation lowers the value of promises to state workers and pensioners, and also is easy to blame on others, it will be an especially tempting escape.

Notice who is missing: Greek bondholders are not being asked to miss a single interest payment, reschedule a cent of debt, suffer any write-down, take a forced rollover or conversion of short to long-term debt, or any of the other messy ways insolvent sovereigns deal with empty coffers. Those who bought credit default swaps lose once again.

But why? The reasoning behind the Greek bailout is founded on several myths that need exploding:

• Saving the euro. We're told a Greek default would imperil the euro.

The opposite is true. Allowing Greece to default, or to renegotiate with bondholders, would be the best way to save the euro. A currency union is strongest without fiscal union. Thencountries are no different from companies. If they borrow and cannot pay back, investors lose money. The currency is unaffected.

The euro could become a monetary union with full fiscal union. I hate to think what EU budgets and taxes would look like if they were all run from Brussels, but at least that system might impose some discipline on national governments' incentive to borrow, spend, and demand bailouts.

But the euro will be a disaster as a monetary union with loose fiscal controls and constant speculation about will-they-or won't-they (or can-they-or-can't-they) trillion-euro bailouts and ECB financing. The Europeans have found the worst possible combination.

How did this happen? The euro's founders wrote rules against sovereign bailouts. They almost created a perfect currency: an international standard of value and medium of exchange, with a central bank mandated only to maintain a stable price level. The euro was not to be devalued to wipe out government debts or to gain temporary (and often illusory) trade or employmentadvantages. In the next U.S. inflation crisis, the euro might have succeeded the dollar as the international reserve currency.

But the euro's founders also set debt and deficit limits. The problem is not that these limits were too loose. The problem is having them at all. The mere existence of the limits says, in effect, that politicians will have a hard time resisting bailout pressure. So the markets lent at low rates and gave high bond ratings. The EU rediscovered that it's much harder to grow a spine in the middle of a crisis.

The euro founders should have said instead, "Go ahead, use our currency if you like. Rack up any debts you want. We don't care, because we are not going to bail you out—we've set it up so we can't bail you out. Bond buyers beware."

The euro founders never decided whether they were creating the perfect currency without fiscal union, or if they were creating a fiscal union on the way to political union. They never decided if the euro was going to be the national currency for a future United States of Europe or a gold standard for the modern age. Now they have neither.

• Contagion.

We're told that a Greek default will lead to "contagion." The only thing an investor learns about Portuguese, Spanish, and Italian finances from a Greek default is whether the EU will or won't bail them out too. Any "contagion" here is entirely self-inflicted. If everyone knew there wouldn't be bailouts there would be no contagion.

• Systemic risk.

We're told that a Greek default will threaten the financial system. But how? Greece has no millions of complex swap contracts, no obscure derivatives, no intertwined counterparties. Greece is not a brokerage or a market-maker. There isn't even any collateral to dispute or assets to seize. This isn't new finance, it's plain-vanilla sovereign debt, a game that hasbeen going on since the Medici started lending money to Popes in the 1400s. People who lent money will lose some of it. Period.

• Saving the banks.

We're told that Greece must be bailed out, or large banks will fail. Savor the outrageous irony of this claim. Apparently, two years after the great mortgage meltdown, Europe's army of bank regulators missed the fact that large, "systemically important" banks had made firm-threatening bets on Greek debt. So much for the idea that more regulation will keep complex banks out of trouble.

If the claim is true (which I doubt), the right answer is to save the specific "systemically important" banks (or, better, their "systemically important" activities), not to bail out every Greek bondholder and the Greek government and to paper over the vast bank and regulatory failure that set up the problem.

Greece got in to trouble when it tried to sell new debt to repay its maturing short-term debt, just as Bear Stearns and Lehman Brothers did. If Greece had sold long-term debt, there would be no sudden crisis. In all the talk of restructuring euro finances, nobody is talking about forcing governments to borrow long-term, nor of managing the crisis by forcing short-term debtholders to accept new long-term debt rather than cash.

Letting someone lose money on sovereign debt is the acid test for the euro. If not now, when? It won't happen in good times, nor to a smaller country. The sooner the EU commits, and other countries and their lenders come to terms with the fact that they will not be bailed out, the better.

The current course—ever-larger and less-credible bailout promises, angry German voters who may vitiate those promises, vague additional fiscal supervision (i.e. more of what just failed miserably)—is not the answer.

The only way to solve the underlying euro-zone fiscal mess (and our own) is to slash government spending and to focus on growth. Countries only pay off debts by growing out of them. And no, growth does not come from spending, especially on generous pensions and padded government payrolls. Greece's spending over 50% of GDP did not result in robust growth and full coffers. At least the looming worldwide sovereign debt crisis is heaving "fiscal stimulus" on the ash heap of bad ideas.

Monday, May 17, 2010

Let me come clean: I basically share the man's distrust of heavy concentrations of power. And I think that secular stability in the general level of nominal prices is probably a good idea too. Thus, it appears that we share a number of beliefs. So why does the guy make my eyes roll whenever I hear him speak?

His problem, in a nutshell, is this: He ascribes too much power to the Fed. The power in the U.S. resides in Congress. It is Congress that spends, taxes, and issues treasury debt. Traditionally, the Fed simply determined the composition of government debt between its interest-bearing (debt) and non-interest-bearing (money) components. What sort of power is this? (Especially in relation to the power of Congress).

Ah yes, but the Fed has greater power than this. It can "lend to its friends" and "let its enemies fail." I presume he is talking about the Fed's emergency lending facilities, all of which have now wound down, with a healthy profit for the U.S. taxpayer.

But I am missing the point: The Fed has the ability to create money "out of thin air!" Whenever I hear this expression, I chuckle. We all have the power to create debt out of "thin air." When Microsoft creates shares to finance an acquisition, it creates the shares "out of thin air." If you bum a beer from a friend and promise to repay him next week, you create a debt obligation "out of thin air." Ooooo..."out of thin air!"

Evidently, Paul has been forecasting the current problems of the world since 1971 (the breakdown of the Bretton Woods system). Yep, there were certainly no problems prior to this. No inflation to speak of. Well, maybe a bit during the Korean war. And maybe a bit more during the Vietnam war. Oh, and let's not forget Lyndon Johnson's war on poverty. Fiscal strain, fiscal strain, fiscal strain...all the fault of the Fed, no doubt. This fiscal strain apparently had nothing to do with the breakdown of Bretton Woods...no, let's just blame the Fed for going off the gold standard. As if Arthur Burns had more power than Richard Nixon.

To be fair to Ron Paul, his position appears to be this. It is not ultimately the fault of the Fed. It is the fault of those in Congress who would like to use the Fed as their personal piggy bank to finance their pet "great society" spending initiatives. What Paul would like to see is an institution that prohibits Congress from making sneaky appropriations through the inflation tax.

If this is his view, then I have some sympathy for it. But I think that his energy here could be better spent elsewhere: there are bigger fish to fry in the realm of fiscal policy reforms.

Both the Greek government and its citizens have blamed international banks for fanning the flames of the debt crisis with comments about Greece's likely default, actions that are causing the country's borrowing costs to soar.

Right. Those big bad international banks (you know...the ones that lent you all that money)...they are now trying to scare everyone into thinking you won't repay! Greek citizens themselves, running amok through the streets of Athens, have done nothing themselves to fan these flames. Nope, nosiree.

Papandreou also said a parliamentary investigation will examine the rapid swelling of Greece's debt and international banking practices to examine whether the financial sector engaged in "fraud and lack of transparency."

I think I may have been wrong: perhaps he is stupid. Shameless, at the very least. Stupid for believing that anyone won't blush at the hyprocisy underlying this statement.

The Greek leader also urged more regulation of the markets which, in his view, are now betting against the European governments that have poured billions into them since the global financial crisis began in 2008.

Yes, yes...let's have a regulation in place that prohibits anyone from taking bets against Greece. What a wonderful idea. Practical too.

"We are ready to make the changes ... we have made our mistakes. We are living up to this responsibility. But at the same time, give us a chance," Papandreou said.

I think that people would dearly love to, Mr. Papandreaou. But you are making it very difficult!

Note to the PM: If you want lower borrowing costs, then why not pawn one or two islands? No one would take you seriously, of course. Which is precisely the point, I'm afraid.

Wednesday, May 12, 2010

Darrell Duffie explains here why speculation is not a four-letter word (In case you do not subscribe to the WSJ, I reproduce the article below).

It's a nice and easy read. But I couldn't help notice that he does not exactly define the term for us (nor, for that matter, do those who wish to pass laws to prohibit the practice).

He seems to identify "speculators" as relatively risk-tolerant agents. These type of agents provide a social good by their willingness to absorb risk, giving the rest of peace of mind.

Of course, their willingness to absorb risk is not necessarily the same thing as their ability to absorb risk. If things turn out very poorly, the rest of us will be asked to absorb the risk. So maybe these "speculators" aren't quite as risk tolerant as they are made out to be (since they have no risk to bear when things turn out badly).

Hmmm...how to define these terms? Perhaps we need some sort of Devil's Dictionary (by Ambrose Bierce, in case you haven't read this--it is brilliant). OK, I propose to hold a contest. Please submit your preferred (cynical) definition of either "speculator" or "speculation." Here's mine:

Speculation (n): The risk-taking behavior of other people.

================================

By DARRELL DUFFIEGeorge Soros, Washington Democratic Sen. Maria Cantwell and others are proposing to curb speculative trading and even outlaw it in credit default swap (CDS) markets. Their proposals appear to be based on a misconception of speculation and could harm financial markets.Speculators earn a profit by absorbing risk that others don't want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment's value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country's default.Is this sort of speculation wrong? I have not heard why.Those who call for stamping out speculation may be confused between speculation and market manipulation. Manipulation occurs when investors "attack'' a financial market in order to profit by changing the value of an investment. Profitable speculation occurs when investors accurately forecast an investment's fundamental strength or weakness.An example of manipulation is an attack on a currency with a fixed exchange rate in an attempt to cause a devaluation of that currency. Mr. Soros allegedly attacked the British pound in 1992 and the Malaysian ringgit in 1997. An attack on the equity or CDS of a bank could create fears of insolvency, leading to a bank run and allowing the manipulator to profit from his attack.In the week of Lehman Brothers' bankruptcy in September 2008, John Mack, then CEO of Morgan Stanley, suggested that the difficulties facing his firm stemmed from such an attack. But firms complaining of unfounded short-selling often had real problems beforehand.A market manipulator can also attempt to profit by "cornering" a market. This is done by holding such a large fraction of the supply of an asset that anyone who wants to buy that asset is at the mercy of the corner holder when negotiating a price. The market for silver was temporarily cornered in 1979-80, when Nelson Bunker Hunt and his brother William Herbert Hunt held silver derivatives representing approximately half of annual global silver production. In the end, the Hunt brothers were unable to maintain a corner. As they sold, silver prices fell, causing them calamitous losses. Market manipulation for profit is not easily done. If the fundamentals of supply and demand suggest that the value of something is $100, then a manipulator must buy at prices above $100 in order to drive the price up or to accumulate a monopolistic position. He then owns an asset that on paper could be worth more than what he paid for it. However, he must sell his asset in order to cash in on his profit. This spurs the price of that asset to fall, as the Hunt brothers learned.Simply driving up the price, as speculators are alleged to have done in the oil market in 2008, is not enough. To make a profit, a manipulator needs to obtain monopolistic control of the supply. Given the size of the oil market, that seems implausible, absent a major and sustained conspiracy.In the United States, trade with an intent to manipulate financial markets is generally illegal. Regulators should keep anti-manipulation laws up to date and aggressively monitor potential violators.Speculation is not necessarily harmless. If a large speculator does not have enough capital to cover potential losses, he could destabilize financial markets if his position collapses. The Over-the-Counter Derivatives Markets Act, which could come up for a vote in the Senate soon, will hopefully reduce such risks.It would be better for our economy to enforce anti-manipulation laws, and require that speculators have enough capital to cover their risks, than to attempt to squash speculation.Mr. Duffie is a professor of finance at Stanford University's Graduate School of Business.

Tuesday, May 11, 2010

It is said that we get the government we deserve. Well, if this is true, then judging by the vitriol spilling out of the mouths of some of our elected representatives, we are all morons.

Here's the latest, from the Nation: Outing the Fed. Some selected tidbits with commentary follow.

Rep. Alan Grayson, the first-term Florida Democrat who partnered with Paul to pass the House version, has a distinctive way of explaining things with brutal clarity. "Fed Chairman Ben Bernanke doesn’t want an audit because Ben Bernanke doesn’t want to be audited," Grayson said. "Treasury Secretary Tim Geithner, the former head of the New York Fed, doesn’t want an audit because Tim eithner doesn’t want to be audited."

This sanctimonious twit should be tarred and feathered for his hypocrisy. (Wouldn't we all love to see the skeletons in his closet). In any case, he continues to propagate the myth that the Fed is never audited. I have addressed this issue here.

Forget all the official blabber about "Fed independence." The central bank has never been independent from the most powerful bankers it is supposed to regulate. The everyday relationship is incestuous. What the Fed and its main constituency of Wall Street power houses really fear is that people will get a better look at their corrupt private dealings. During the financial crisis, the central bank handed out something like $2 trillion in emergency loans and other goodies. All efforts by Grayson and others to find out who exactly got this money were rebuffed by the Fed governors. Bloomberg sued for disclosure and won in Federal court. The Fed is appealing the ruling.

Please explain this "everyday incentuous relationship" that the Fed evidently has with the big banks it is "supposed to regulate." As I explained here, the Fed has primary regulatory authority over only 15% of the nation's banks (whether measured by number of banks, or by assets). What on earth are they talking about here?

Yes, during the crisis the Fed did "hand out" something like 2 trillion in emergency loans (and other "goodies"? like what?). What is conveniently ignored here is that most of this emergency lending has been repaid with penalty interest rates. Perhaps they have failed to notice that the Fed remitted an extra $25 billion or so in 2009 to the Treasury; see here. Yes, yes...I demand to know who the Fed lent all this money to that was ultimately repaid with a very high return! Who were the recipients of this bailout!? (Blah, blah, blah...in the meantime, with Congress handing out bona fide bailout money to its favored special interests...)

Sunday, May 9, 2010

George Selgin has written an interesting piece here, explaining why the institution of central banking is inherently destabilizing (relative to an institution of free-banking). I have a lot of sympathy for what he has to say here, although I do have some reservations. (Thanks to Prof J for sending this to me).

Selgin begins by describing how a free-banking systems works. Competitive banks issue paper liabilities made redeemable on demand for specie (historically, these paper notes also constituted senior claims against the bank's assets in the event of bankruptcy; i.e., they were backed beyond the available specie held in reserve). Banks would create these notes whenever they wanted to make a money loan. The money loan would be extended against sufficient collateral (hence, the paper issued by the bank was backed, at least in part, by the collateral backing its loan portfolio).

Question: what prevents individual banks from "over-issuing" the paper money that they can evidently create "out of thin air?" Answer: the principle of adverse clearing. What is this? As banknotes circulate, a portion are redeemed for specie (either directly by people, as when you or I visit an ATM, or by other banks who have received deposits consisting of other banks' notes. This continual flow of redemptions is what keeps the supply of credit in check: banks that issue too many notes will have trouble honoring their redemption obligations, leading to bankruptcy.

I have some sympathy for this argument, but I wonder whether it is entirely correct. One might note that Microsoft shares are not made redeemable on demand for anything (although they are backed by capital). What prevents Microsoft, or any other company for that matter, from "overissuing" its debt obligations? There is no principle of adverse clearing at work here.

A central bank is defined by Selgin as an agency that has monopoly control over the supply of small denomination paper notes. As Selgin rightly notes, the monopoly was usually conferred by resource-hungry sovereigns. Private banks would deposit their specie with the central bank, and issue liabilities (checkable deposits) redeemable in central bank money (rather than specie). Or something like this...practices likely varied across space and time. In any case, the point is that the central bank is no longer subject to the force of adverse clearing.

If I understand his argument correctly, all I think he is saying is that the central bank is now in control of the object of redemption (specie in free-banking). There is very little economic discipline on how a central bank manages the base money supply. It can overissue, leading all banks who make their liabilities redeemable in central bank money, to overissue as well. A credit bust inevitably follows the resulting boom in credit.

Well, I suppose. On the other hand, an independent central bank might choose to keep the supply of base money in check. What is the difference now between bank liabilities made redeemable in specie or central bank paper? In fact, the latter might be superior in that it frees the specie from its role as idle reserves...the gold and silver can now be used for other purposes.

Of course, central banks have behaved badly in the past. But this has almost always been because of pressure from the fiscal authority. Even a free-banking system is not free from the grabbing (and destabilizing) hand of the state.

Overall the biggest slice of the farm subsidy cake still goes in direct payments for farmland. But even in this category there is controversy.

Providing the land is cared for and meets environmental standards, it does not need to be farmed to qualify for a subsidy. Mere ownership is enough, and therefore the wealthier the landowner, the larger the handout is likely to be.

The queen of England qualified for £473,500, or $778,812, in total farm aid in 2008 for Sandringham Farms in England, a 20,000-acre royal retreat that has been a private home to four generations of British monarchs since 1862. A pet project of Prince Charles to preserve the Transylvanian countryside also qualified for a nominal sum. Prince Albert II of Monaco collected €507,972 in 2008 for his wheat farms in France.

The duke of Westminster — the third richest person in Britain with a fortune estimated at £6.5 billion — collected £486,534 for his farm. Top Farms, the duke’s Polish distributor for his bull breeding company, Cogent, collected more than €8 million in subsidies from 2006 to 2007 for its dairy farms in Poland.

Tuesday, May 4, 2010

A number of my colleagues and myself (at the FRB St Louis) attended a meeting yesterday with Paul Volcker to hear him opine on the so-called Volcker rule. (He spoke later that evening at Washington University; see here). I haven't followed the debate on financial sector reform very closely, so I learned a few things.

The central "problem" is the too-big-to-fail issue. How do we deal with it? Enter the Volcker rule.

If I understand correctly, the Volcker rule consists of two parts: [1] A rule determining which institutions are in and out of the social safety net; and [2] A rule determining how institutions out of the safety net, yet important to the financial system, are to be treated in the event they become distressed.

In a nutshell, rule [1] says you are in if you act like a traditional deposit-taking bank. If you want to engage in proprietory trading, then fine, but you will not be included in the safety net (e.g., access to the discount window). Rule [2] consists of some sort of "resolution authority" with the mandate to take over any troubled financial firm that threatens the system, and liquidate its assets in a timely manner. These firms will be allowed to fail.

I do not think that Volcker pretends that this is the solution to the TBTF problem or that this rule, in itself, will lead to perpetual stability. He seems to think, however, that it is an important first step. Well, naturally we had a few questions.

I decided to bring up a few points raised by Steve Williamson here on why TBTF does not seem to a problem in Canada. He replied that Canadian banks were more prudent in their lending. I tried Steve's line that this was likely the product of better regulation; there is no Volcker rule, as far as I know, in Canada. His reply, at least a part of it, was that Canadian banks did not engage in a lot of proprietory trading anyway.

Well, what could I say? I let it lie there. There were, after all, many other things to talk about. I thought it interesting that he brought up the issue possible systemic risk among those firms outside the safety net. Could the resolution authority really be expected to shut down a large "non bank" financial player? He seemed well aware of the shortcomings and delicate issues involved with any regulatory proposals. Some of his interesting (radical?) views can be found here.

He has quite the sense of humour too, I must say. On Goldman Sachs and conflict of interest he said that GS reminded him of an apple (possibly NYC) full of worms. GS is so intertwined in the finanical sector that every trade they make is a conflict of interest.

The best part, however, was when during one of his explanations, a cell phone started ringing softly. He stopped talking and looked around, but soon discovered that the offending piece was his own. So he leans back in his chair and slowly pulls the phone out of his pocket. He opens it, brings it slowly to his ear and with a deadpan delivery barks out: "Let them fail!" ...and then immediately hangs up.

But why is Greece worth "saving" at all? Well, I love this part. The reporter says "Well just look around...Greece is a huge export market for Germany...just look at all the Mercedes, BMWs, and Audis parked around here!!" (He is in Greece, with the Parthenon in the background as he is saying this).

Now, just hold on there a sec and let's see if I have this right.

German workers bust their butts manufacturing automobiles. Rather than ride them around themselves (an act of consumption), they prudently decide to export all these fancy cars to Greece (an act of saving). Greeks can't manufacture these automobiles themselves (or produce enough olive oil to pay for them) because...well, you know...you can't do this and expect to maintain a decent tan, perhaps. So, the Greeks borrow the cars (an other goods, of course, like suntanning lotion and skimpy German-made thongs perhaps). Greece issues a collective IOU to pay for these things.

But now Greece is having trouble paying back its debt to the Germans. If they default, they won't be able to afford any more German-made automobiles! The German export market will dry up, leaving German auto workers idle!

And to prevent this from happening, the German government stands prepared to tax its citizens to pay for (or at least subsidize) Greek debt, i.e., the German cars it sends to Greece...so that German workers can retain the privilege of working hard and shipping even more cars to Greece? What is this guy thinking (he is not the only one I hear speaking in this way)?

I don't get it. But then again, perhaps this is one reason why I don't get calls from CNBC soliciting my opinion!

Sunday, May 2, 2010

The empirical evidence shows that throughout history, money (broadly defined to constitute assets that circulate widely as media of exchange) takes the form of debt. In the past we saw banknotes redeemable in coin with senior claim to bank assets. Today we have government-insured demandable bank liabilities redeemable in government fiat. More broadly, it is notable that the collateral objects that "circulated" in the repo market were debt instruments (e.g., US treasuries and AAA rated MBS).

Why do we pay for things using bank debt rather than bank equity? To put things another way, why is debt more "liquid" than equity? What is the link between liquidity and the optimality of debt?

There is, of course, a literature that explains the optimality of debt (e.g., Townsend, Hart and Moore). The focus of this literature, however, is on the primary market and not on the secondary market; that is, they do not link the optimality of debt to liquidity. There is also a literature that studies liquidity provision, but simply assumes the optimality of debt (e.g., Diamond and Dybvig).

I am not an expert in corporate finance, but the theory of debt laid out in this paper seems somewhat different from, say, Townsend's costly state verification model. In Townsend, the security issuer has private information over the realization of the project. The security purchaser has an ability to discover this information at some cost. Costly audits are a social waste, so it is desirable to minimize this expense. Equity finance is terrible in this regard because the purchaser must audit all the time. Debt, on the other hand, triggers an audit only when the security issuer reports terrible outcomes.

Dang, Gorton and Holmstrom (henceforth DGH) have a setup where project realizations are publicly verifiable ex post. The twist in their setup is that prior to exchange, agents have an opportunity to discover the true project realization at some fixed cost. Consider two extremes: the audit cost is zero or infinity. Question: which world would agents rather live in? Answer: ex ante welfare is maximized under ignorance. The intuition for this is similar to Hirchleifer's (AER 1971) classic result; although agents in DGH are risk-neutral.

So their first result is that symmetric ignorance dominates symmetric information (even if such information is costless). Imagine that the security issuer and purchaser both face the same cost (k) of discovery. Is it possible to design a security that gives both agents the incentive not to acquire private information?

Let x denote the project outcome, distributed according to cdf F(x). Let s(x) denote the security's promised payout in state x, and let p denote the price of the security. Since the purchaser is risk-neutral, he is willing to purchase the security (without scrutiny) if p = E[s(x)].

The problem here is that the purchaser will view himself as having "overpaid" for the security in bad states of the world; i.e., for all x such that p - s(x) > 0. The expected cost of overpaying in this manner is given by v = E[max{p-s(x),0}]. DGH show that v is the value of information to the purchaser (they also show that the corresponding value for the seller is always smaller, so we may, without loss focus on the buyer). If v < k, then no party has an incentive to acquire information (preserving symmetric ignorance).

Note to reader: this program does not seem to handle mathematical formulae well. After several attempts at editing without the desired result, I will try to explain as much as possible in words only.

DGH demonstrate that because debt is senior, it reduces the probability that one will overpay (ex post) for the asset, hence it reduces the incentive to acquire information to make sure that one is not overpaying.

If v(debt) < k < v(equity), then the existence of leverage will support trades that would not otherwise have occurred. Leverage lifts the economy higher. But of course, when something is created, one automatically creates the risk that it might collapse. DGH have in mind the arrival of bad news in the form of a public signal (e.g., declining real estate prices). The effect of such a shock may be to render k < v(debt); which is to say, it suddenly pays to acquire information on debt. Such information acquisition, while privately optimal, is socially suboptimal -- it has the effect of generating asymmetric information and adverse selection -- which further hampers the liquidity of debt beyond the effect of the fundamental shock (the bad news). It is in this sense that a fundamental shock can lead to a systemic event.

If you are motivated to read the paper, please let me know what you think about it. I think that the authors are on to something; but I'm not absolutely sure whether the details all hang together. I'd also appreciate references to related literature.

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The Democrats are the party that says government will make you smarter, taller, richer, and remove the crabgrass on your lawn. The Republicans are the party that says government doesn't work and then they get elected and prove it (P.J. O'Rourke)

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